Understanding the Over-the-Counter (OTC) Market: Comprehensive Analysis of Operation Mechanisms and Investment Characteristics

When investors are interested in a company not listed on mainstream exchanges, where should they conduct their transactions? This is precisely the value of the OTC (Over The Counter) over-the-counter trading market. OTC trading attracts more and more participants seeking alternative investment channels with its flexible trading modes, diverse product options, and customized trading solutions. However, compared to regulated centralized exchanges, OTC trading also involves higher risks. What exactly is OTC trading, how does it operate, and how can one participate safely? This article will analyze each aspect in detail.

Core Definition of OTC Trading

OTC (Over The Counter) refers to a trading method where the two parties do not rely on a centralized exchange but instead conduct transactions directly through dispersed channels such as banks, brokerages, electronic systems, etc., involving securities, commodities, and other financial products. This form of trading is also called “over-the-counter trading” or “OTC trading.”

Unlike the unified bidding mechanism of centralized exchanges, OTC prices are negotiated directly between buyers and sellers, involving a variety of counterparties including banks, brokerages, corporations, and individual investors. Many small and medium-sized enterprises or startups that do not meet listing requirements choose to raise funds and trade in OTC markets; some established companies with listing qualifications prefer to stay OTC for business reasons (such as avoiding excessive disclosure).

With the development of internet technology and the expansion of global financial markets, the OTC market size has grown rapidly. Investors’ demand for trading convenience and market accessibility continues to rise, making OTC an indispensable part of the modern financial ecosystem. However, compared to on-exchange trading, OTC trading has lower price transparency, looser regulation, and higher trading risks.

Types of Products Covered in OTC Trading

The products in OTC markets far exceed traditional stocks and bonds, covering various financial derivatives:

Stock Market: Besides listed targets, OTC markets host numerous unlisted stocks of small and medium-sized enterprises and startups, providing financing channels for growth companies.

Bonds: Due to large issuance volumes, diverse types, but infrequent trading, OTC markets are more suitable for bond transactions than centralized exchanges.

Derivatives: Options, futures, spread contracts, and other contractual products are traded flexibly OTC and can be customized according to specific needs.

Foreign Exchange (Forex): Currency trading conducted on various platforms is all OTC mode.

Cryptocurrencies: Mainstream cryptocurrencies can be traded OTC, allowing investors to purchase large amounts of digital assets in one go, which is difficult to achieve on dedicated crypto exchanges.

How the Taiwan OTC Market Operates and Its Rules

Taiwan’s stock market is divided into two tiers: the “Stock Exchange” and the “OTC (Gretai) Market.” The OTC index compiled by the Gretai Market reflects the overall condition of Taiwan’s OTC stock market and serves as an important indicator for investors observing small and mid-cap stock trends.

The government established the Gretai Market to maintain standards for listed companies while lowering listing barriers for growth-oriented enterprises. If a company receives recommendations from more than two qualified brokerages, it can enter the OTC market; if within six months the company’s performance improves (such as turning profitable or strengthening its financial health), it can apply to move to the main or OTC market.

Daily OTC trading process includes the following steps:

Step 1: Investors place orders through brokerages, same as buying listed stocks.

Step 2: The order is uploaded to the Gretai Market’s automatic matching system (ATS), which matches trades based on price priority and time priority, with technical rules aligned with the main market.

Trading hours and call auction rules:

Call auctions occur every 5 seconds, with price fluctuation limits of ±10%, identical to the main market rules. Additionally, the settlement system for OTC stocks is T+2, meaning settlement occurs within two working days after the transaction.

Overall, Taiwan’s OTC market mainly involves small and growth-oriented companies, with higher volatility but rich in themes. Due to better liquidity than the Emerging Stock Board (興櫃), and with regulations and listing standards similar to the main market, the entry barrier for general investors is not high. However, smaller company sizes may be more susceptible to news and market sentiment, so caution is advised regarding stock price fluctuations.

Seven Key Differences Between OTC and On-Exchange Trading

The emergence of centralized on-exchange trading aims to establish uniform standards and rules. In contrast, OTC trading aligns more closely with the fundamental supply and demand principles in economics. The main differences are as follows:

Product Standardization: On-exchange trading is like uniform banking services with consistent standards; OTC trading is akin to pawnshops—each situation varies, but the range of tradable products is broader.

Trading Mode: On-exchange trading’s transparency ensures fairness but limits profit margins; OTC trading involves negotiation, where information and capital scale are less critical than the ability to negotiate.

Product Diversity: On-exchange products require a certain market size, limiting variety; OTC products are diverse, including forex CFDs, cryptocurrencies, unlisted stocks, etc.

Regulation and Security: On-exchange trading is operated by government-approved exchanges under full regulation; OTC markets are operated by brokerages with only partial regulation, posing risks of fraud.

Transparency and Information Gap: On-exchange markets disclose all trading details; OTC markets lack mandatory disclosure, allowing those familiar with rules to profit from information advantages, while others may suffer losses.

Liquidity and Trading Volume: Centralized exchanges attract international capital, resulting in large trading volumes and high liquidity; OTC markets have relatively weaker liquidity.

Operational Flexibility: On-exchange markets have strict risk controls, with leverage and short-selling restrictions; OTC trading has fewer restrictions, offering more flexible strategies.

Advantages and Risk Assessment of OTC Trading

Core Advantages of OTC Trading:

✓ Wide Investment Options: OTC markets open more investment avenues, including derivatives, binary options, CFDs, forex, and more.

✓ Flexible Trading Modes: Products and trading methods are diverse, allowing investors to customize trading plans based on their goals.

✓ High Leverage: Compared to traditional markets’ leverage limits, OTC offers higher leverage multiples, facilitating amplified gains.

✓ Enhanced Security: Modern OTC markets have implemented multiple layers of security; some brokers are authorized and regulated by reputable financial institutions, increasing professionalism.

Main Risks of OTC Trading:

❌ Loose Regulation: OTC markets lack unified rules; legal oversight is weaker, making fraud by unscrupulous brokers easier. Listed companies and securities must follow strict regulations; non-compliant enterprises can only trade OTC.

❌ Low Liquidity: OTC securities have lower liquidity than those on centralized exchanges, making it difficult for investors to execute trades at desired prices quickly.

❌ Market Volatility Risk: OTC investors often lack transparent information, facing higher market volatility. Some products are highly volatile with low liquidity, increasing risk.

❌ Counterparty Risk: Negotiated pricing means investors face credit risk from trading partners.

❌ False Information Risk: There is a possibility of malicious actors spreading false information to deceive investors.

How to Assess the Safety of OTC Trading

Does the lack of exchange regulation mean OTC trading is unsafe? Not necessarily. Compared to centralized exchanges, OTC does carry higher risks, but proper choices can mitigate these risks.

Root causes of OTC risks: The absence of unified rules, with buyers and sellers negotiating prices, can lead to counterparties quoting different prices to different buyers. This results in counterparty credit risk, large price swings, and low liquidity. The market also has fraudulent actors using false information to scam investors.

Key measures to enhance OTC safety:

First, verify the broker’s compliance: Choose brokers regulated by multiple authorities with strong risk management capabilities. Legitimate platforms implement investor protection measures, including risk assessments, KYC (Know Your Customer), complaint mechanisms, etc.

Second, select mature trading products: Prioritize highly liquid products like forex with transparent spreads, and evaluate withdrawal convenience and other factors comprehensively.

Finally, improve your own knowledge: Investors should thoroughly understand the characteristics, market rules, and risk features of the traded products to avoid blindly following trends.

Conclusion

OTC markets, with their flexibility and diversity, open up investment opportunities beyond traditional centralized exchanges. Whether professional investors seeking higher leverage or institutional clients aiming for specific product exposure, OTC provides tailored solutions. However, greater freedom comes with increased risks. Investors should choose reputable, well-regulated trading platforms, deepen their understanding of market mechanisms, carefully assess their risk tolerance, and only then can they profit steadily in the OTC market.